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The Beauty of the Oil Market

May 20, 2007 3:54 pmMay 20, 2007 3:54 pm

It’s busy season for gas station attendants — with prices for a gallon of regular unleaded bopping around $3.11 nationally, they need to change their signs at least once a day. Many drivers hate these price changes, and I see their point: Not only are rising gas prices a financial burden; they also function as a sort of emotional baseball score — an index of American economic health. When prices are high, anxiety rises.

But for me, watching rising and falling gas prices is more fun than watching baseball. Prices are a visible indicator of the bizarre opera-meets-Rube Goldberg machine that is the international crude oil market and the domestic gasoline market. Is today’s problem a refinery outage in Texas? Or the aftermath of Nigeria’s elections? Gas prices offer a window into the giant brain of the fascinating, unpredictable and highly useful oil market. And if you stare into it long enough, you can see how these crazy price swings may help bring us alternative fuels.

In the old days, gasoline prices rarely changed, because there were no energy markets at all. In the 1960s, prices stayed the same for so long that the numbers literally rusted on gas station signs. Many stations didn’t even bother to post prices, figuring that an offer of Green Stamps would be enough to lure drivers into the station.

The stable prices reflected a larger reality: For many years, crude oil prices were set by oil-company executives who made long-term deals with oil producers. Prices were known only to a few, and they didn’t change much. In 1976, the posted price of Saudi crude oil was $12.37 a barrel for the whole year. Without an open market for crude, the 1973 Arab oil embargo was somewhat successful in preventing oil shipments from reaching the United States.

After that shock, a crude market evolved, pushed along, according to economist Philip K. Verleger, by changes in monetary policies, deregulation and a United Kingdom tax scheme that required some stocks of North Sea oil to be sold on a daily basis. In the late ’70s, the New York Mercantile Exchange began trading heating oil, and in 1983, it also began trading futures for crude oil. Other markets evolved, including the gasoline spot markets.

You can see the crude oil market at work at the New York Mercantile Exchange’s crude pit. Dozens of traders buy and sell “paper” barrels of crude in open-outcry trading. It’s a tremendously loud, sweaty tangle of adrenaline, crisscrossed by the cords of telephones held by hundreds of analysts, who stand by the side of the pit giving the traders buy and sell orders they’ve received from refiners, oil producers, hedge funders, speculators or anyone else. On the walls around the pit, prices appear on digital readouts, interrupted by the news of the day.

The traders compare the pit to a giant brain, and out of it comes an agreed-upon price for the paper barrels, a k a futures contracts, which guarantee delivery of oil any time between one month and six years ahead. From this furious trading comes the price of nearly every barrel of real oil produced in the Western Hemisphere, and to some extent the world. (See how Chevron prices crude east of the Rockies here.)

The oil market is the ultimate economic democracy — anyone with access to a computer can find out the latest price for crude.

“The NYMEX opened up the pricing of oil so that it happened in public,” Dan Brusstar, vice president of research at NYMEX, explained to me. “And the price arrived in an open competitive environment, which made the prices a better reflection of the market. That was a revolution compared to what was happening before.”

Information from the market permeated the economy, to the benefit of oil companies and individual home-heating-oil buyers alike. Just as oil refiners can now buy and sell futures contracts as a hedge against volatile prices, New Englanders can hedge their heating oil costs by buying futures through their local oil company.

What’s surprising is that in some parts of our economy, the prices are still rusted to the signs. Take your electric bill, for instance. On a hot day, when demand for electricity is high, the cost of running your drier may be four times the actual cost it would be if you ran it at midnight, when demand is low. But you’ll never know that from reading your electric bill, because the price per kilowatt hour is averaged so that each one costs the same.

Without market information, consumers fly blind, which means that our electrical system, though it has been overbuilt, is still sometimes overwhelmed. Being able to see how the market works for electricity — that is, having meters in our homes that display real-time prices or that shut down at high-priced times — could solve some of our electricity supply problems. (The University of California’s Center for the Study of Energy Markets has some thoughts on this.)

Markets also suggest how alternative fuels may one day compete without huge government subsidies. When oil and gas prices are highly volatile, some alternative fuels can act as a hedge because their prices are predictable. For example, power from alternative sources like solar and wind can be made at a fixed price, which could be used to insulate a company against the up-and-down gyrations of the natural gas markets. Real Energy, a California company that generates power for large buildings, plans to build several plants to produce biogas from cow manure at around $6 per 1000 cubic feet. “As long as the dairy is getting milk, they’ll have manure,” said Kevin Best, Real Energy’s chief executive. “It’s better than being a wildcatter, because every cow makes gas. There’s very little risk.”

As markets allow alternative fuels to become more mainstream, the resources needed to make those fuels may start to trade on their own markets. Recently, I was talking with someone who’s working on making fuel from garbage. “Someday we expect there will be a New England Garbage Exchange,” he said. That gets right at the beauty of the market — you could even trade garbage.

This analysis was very helpful, but I have yet to see anyone explain clearly why the oil companies’ profits are rising so sharply along with gasoline prices. The oil companies say that their pricing is based on the price of crude, but if that were the case, their margins would remain the same and they could be free of charges of price manipulation.

I believe some market forces are at work. I also believe oil companies are extracting the highest profits possible from what has become a national — and a national security — resource. They realize they can do so because they have an administration that they’ve bought and paid for, and there are no other forces in the U.S. powerful enough to challenge them.

I saw the “beauty” of the market at work last weekend, when I was on a trip to Massachusetts. I bought gas at $2.94 per gallon, some 30 cents below the prices in New York. A few hours later, on a Friday evening just before a sunny weekend, I passed by the same station and the price had jumped four cents. In this case, the market force at work appeared to be greed.

We need some kind of national energy policy that permits the oil companies to make a profit fair enough to ensure they can continue exploration and upgrade refineries (something they haven’t done here in the U.S. for several decades). Beyond that, some kind of government regulation is necessary to protect consumers as we move toward alternate energy sources.

I’m not advocating a Chavez-style takeover, but, clearly, the oil companies care not one bit about the American public and the effect of gasoline price-gouging on our economy.

I traded oil and petroleum products from the mid-1980s to mid-90s. You’ve nicely captured the feel and excitement of these markets. The more people understand how energy trading really works, and how it creates efficiency, rather than collusion, the better.

As glamorous as the NYMEX traders are, however, they aren’t the ones who make the supply chain from refinery to gas pump seamless and efficient. That job belongs to a large cohort of invisible oil company traders and pipeline schedulers, working literally 24/7 to optimize supplies and compensate for all manner of disruptions.

The unit of electric energy delivered to the consumer is the kilowatt-hour, NOT the kilowatt. Getting the terminology right is crucial to developing a belief that the reporter understands his/her subject. COST per kilowatt (NOT price per kilowatt) is a measure of the cost of building electricity-generating and/or transmission facilities.

all that’s missing from the column and the picture is that “Nevermind!” ala SNL. Of course people that play the market and live by it’s inefficiencies will applaud the article. I trust that people are sensible, that they are motivated by purpose. Most of this is accomplished far far this side of avarice.
But a fluxuating market never attracts investment capital. It attracts speculation, quite naturally and quite sensibly.
Why invest at risk for the long term when one can invest for the short term with an almost certain return with market periodicity?
Each time alternatives appear, the larger players will lower prices. When prices drop, they will raise them (Remember California generating being pulled off line for maintenance? notice the current maintenance of refineries? That behavior is so utterly sensible and to make any other behavior financially irresponsible.)

Your explaination about the Market Forces that are currently extant is rather reminiscent of the explainations about energy prices before the revelations of the Enron scandal. We were assured that it was simply a matter of these magical forces playing out their manifest destiny. However, I pause, when I read that the oil companies are making profits, at astonishing rates. Rates that have never before been seen. There are giant forces at play, but your piece does not deal with the most important ones.

You make an interesting assertion that the electrical system “has been overbuilt” without any evidence. However, perhaps of more interest to readers would be an explanation of why overbuilding occurs: the ability of somewhat regulated territorial monopolies to obtain certificates of public need and profit from building new capacity: making money from the infrastructure and the electricity it generates and transmits.

By the way, real time electricity pricing (as paid by transmission and distribution companies) is available at //www.pjm.com/index.jsp

A well-informed article, but why do we have to genuflect to that true bastion of greed, alternative energy? The scale of the duplicity amongst hucksters who shamelessly promote “green” alternatives is to be rivalled only by the gullibility of those wasting (yes, wasting) money on solutions that are almost always much worse off for the planet.

Take bioethanol – the most egregious (but certainly not the only) example of how a combination of politics and money creates bad outcomes for the planet and the population. It takes far more energy and produces far more carbon to produce a gallon of ethanol (think gasoline to power the harvesters that gather the (well-fertilized) corn that needs to be crushed in an energy-intensive process, then shipped via a truck from Nebraska to the East Coast) than mineral gasoline. The only winners from bioethanol are a few lucky investors and agri-business – ADM and Cargill. The same holds true, to varying degrees, for solar, wind, biomass, etc. A few US developers and Taiwanese and German companies make tons of money and a few hundred people wind up with stupid-looking things on their roofs or giant windmills in their back yards.

I also find it interesting that the general population always wants to pillory big oil for the profits they generate while the stockmarket has pilloried them for the profits they’ve failed to generate.

Keep in mind that the oil companies all have vast storage and excess capacity in reserves and inventory. They do not just go out to the spot market and buy oil and send it to your local pump. The gas you will pump 45 DAYS from now; Exxon already had that oil bought and paid for (likely hedged through multiple contracts as well). If you check your Bloomberg Terminal, type CMDS crude oil is currently at 65.12. And for 2007, black gold has been on the rise and consequently your unleaded gas…demand from China/India, cut supplies from Iraq and Nigeria, costs of refining, and so forth.

What has been the case for some time is contango in oil futures markets. The forward curve has been upward sloping so month over month contracts experience negative roll yield; as prices are going up, the reason the profits are at records is that the oil companies have already bought the oil in advance of the current spot (don’t necessarily correlate gas price at your pump to the NYMEX oil futures market). People–as well as the author of this article, need to differentiate between the different “players” in the global oil game. The boys at the pit of the NYMEX are nothing more than mere market-makers and specialists executing orders. Yes, they are helping determine fair price (and it is a lot of fun on the floor), but they are not taking the outright positions or the ones making orders. It’s those “clients”: I-Banks, Hedgies, Funds, Producers/Refiners that are all “paper-trading” on information flow, fear, speculation, etc. The real tough guys trade on delivery…

Anyway, I’m kind of getting off point. Think of it this way, if Exxon locked in oil at $78/barrel then they’d be screwed right now. But they didn’t–it is locked in much lower than that–lower than current spot, even. Thus, what is happening with the oil companies is they essentially are buying in at locked in [lower–relatively speaking to spot] prices but are selling based on current market conditions.

Given that the United States is a capitalist society and capitalism has proven to be the most efficient (albeit not perfect) means of allocating scarce resources, it ceases to amaze me, how many of its citizens advocate socialist policies when it comes to oil and gas. Here’s a better idea – take the bus, by a hybrid, or drive less. Since, as a whole, U.S. citizens are not doing that, it seems the price of gasoline is quite fair.

I love the analysis, but have a hard time with the conclusion that the market dictates gas prices.

If, at the end of the day, the oil and gas companies were making a decent profit, no matter if the price is high or low. Then I would agree. But each quarter the oil and gas companies announce billions and billions in record profits.

Why is it difficult to see that these companies are making obscene profits and doing extreme hard to the country.

If they were doing this following a major storm on the east coast, they would be jailed. So why not now?

No question that the market, to at least some extent, sets the price of a commodity. However, there’s also no question that markets have been manipulated to the benefit of suppliers in the past. Only a few short years ago, Enron (remember them) was pushing the mantra that unregulated markets could only work to the public good, in the form of lower prices, at the same time as they were busily manipulating the availability of electric power in California. Guess who benefited from that one?

Refining oil is a service whose cost varies only slightly with the market price of oil. Yet refiners have been charging far above their normal costs. It used to be fifteen cents. Let’s double it for no good reason: 30 cents. How come one reads of refiners getting up to a dollar per gallon and more, and how come one learns that foreign refiners are stumbling all over themselves to export refined gasoline to the US? Are refiners doing the real price gouging??

The myth that market pricing is rational and/or desirable is supported only by the theoretical presumption that the market is “free” from monopolistic manipulation. Where supply is controlled by a handful of purveyors, as in the case of oil, the market is anything but free. It’s tempting to think that nationalization of our total energy supply might be a boon, but government is as susceptible of corruption as is private enterprise, human nature being what it is.

To be sure we have enough of this amazing chemical to meet the real needs of people,a BTU tax applied on everthing we use is required. This tax on the energy required for the production of goods and delivery of services.

Such an approach could contol carbon consumption, limits emmissions and drive (pun intended) our transporation system into the physical limits of real world.

The tax rate applied individually as in WW-II gas rationing would provide equity for those of us who actually have to work.

Real public policy on energy; what a dream! I look forward to your book…

What is needed is complete transparency in the pricing of petroleum products to consumers, industry and the government. Price out of the refinery and mark-ups at the wholesale and retail levels. The only thing we hear about is the speculative price of a barrel of crude.
We also need to know whether the Bush administration keeps buying petroleum products for the national reserve, when the supply tightens because of refinery or delivery problems.
All we know for sure that the oil industry is reaping huge profits, which increase with every stumble of the “market”. We do not have a free competitive oil industry. They constitute an unspoken monopoly and gauge the consumer and the government for all they can get.
Iraqis pay under a dollar per gallon, though the refined product is likely trucked in by “occupation” convoys. I bet the army is also paying a steep price, much more than the Iraqis.

So let me get this straight, in your quick petrol-economics history lesson what you’re not saying is petroleum prices are going through the roof since the 1970’s and show every indication that they will continue to rise because of the so-called democratization of the free market? How is this better for the average person? A system that allows us to see how we are getting screwed is not democratic if this system only allows participation by the hyper-rich. This is an oligarchy, not a democracy.

Oil market simply isn’t a market at all. It is highly sensitive on the edges. A big producer like Saudi Arabia can easily force the price up or down as it desires by manipulating a relatively small percentage of overall production.

A parallel system exists in the domestic refinery capacity. A carefully scheduled maintenance event at the demand upswing in one or two refineries has an inordinate influence on the price at the pump.

You may choose to believe this is a freely functioning market but in reality it is a precisely designed legal scamming system. The price is manipulated in waves. The price goes up but it stays up just long enough so that people do not permanently adjust their lifestyles to lower energy consumption. Then all of a sudden the prices come down.

Thank you for a wonderful, unemotional and, at times, humorous look at the oil industry as it relates to gasoline prices we pay at the pump. It has been my understanding that the margin of profit that the oil industry makes on the product it sells has remained constant at approximately 5-6%. It stands to reason that their numerical profits have risen proportionately with the price of crude. When will we turn our ire onto those in OPEC, who have a virtual monopoly on the price of oil via the supply-side of the equation.

This country should have been long into the process of finding affordable and profitable alternative energy sources to remove our dependency on OPEC. If there is a failing of leadership in this country, let’s indict Presidents Reagan, Bush 41, Clinton and Bush 43 for shamelessly ignoring an issue of strategic importance to this nation. Oh, and let’s not forget to indict the American consumer and his gluttenous appetite for petrol.

Could someone please explain how complicated the oil company supply chain is? Could you also explain how a few huge corporations have almost exactly the same supply chain and/or operations and/or delivery expenses so they have to charge within a few percent of each other at the pump?
If the costs cannot be controlled than who needs the corporations? What are they doing for their money. It sounds like the answer is nothing much in which case why not nationalize the companies. They are already!